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Tuesday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, we'll be looking at two analysts with dueling views over the future of the auto industry -- or, rather, the future of the suppliers that feed into it. On the one hand, Goldman Sachs is betting that Ford's (NYSE: F) move to sell "aluminum trucks" will be a success, and picking two aluminum companies to profit from it. Meanwhile, rival megabanker HSBC still sees...

A future for ArcelorMittalWorld's-biggest steelmaker ArcelorMittal (NYSE: MT) announced its Q4 2013 results on Friday, reporting a loss of $0.69 per share on $19.85 billion in revenues. That's the bad news. The good news is that revenues were up year over year and losses down. Now, management is reporting improved profit margins from its steel business, and modest growth in steel shipments of 3% in 2014, as compared to 2013 volumes.

All this has HSBC feeling optimistic about Arcelor's chances, and according to Briefing.com, upgrading the shares to overweight. Is that the right call?

I don't think so, and I'll tell you why not. At today's market cap of $27.3 billion, Arcelor shares cost 32 times the company's trailing free cash flow. (You can't value the company on P/E, because... it has no "E." No earnings at all.) True, analysts who follow the company expect Arcelor to grow its earnings at upwards of 50% annually over the next five years (according to Yahoo! Finance). But again, with earnings currently negative, it's hard to figure out what "growing" these nonexistent earnings really means. To me, the projected growth rate is essentially meaningless.

In short, Arcelor's expensive valuation, heavy debt load ($16 billion net of cash), and relatively meager dividend yield (1.2%) all tell me that this stock is no bargain, and certainly not a stock you'd want to "overweight."

Aluminum: Metal of the future?Additionally, there's still the matter of Ford's switch to new, aluminum-bodied F-150s to consider. Decreased steel consumption by Ford won't be good news for steelmakers. And according to Goldman Sachs, the situation could be even worse than that.

Arguing that the "Ford F-150 is the tip of the iceberg, and expect several other automotive platforms from all major OEM's to move toward partial or full aluminum [usage] in coming years," Goldman predicts that "gradual conversion of automotive exposed body to aluminum (Body-in-White or BiW) will be a game changer for downstream aluminum use." Quoted on StreetInsider.com this morning, Goldman predicts "significant growth in the automotive aluminum sheet market" -- on the order of 14% compounded growth over the next 10 or more years. This prospect has Goldman recommending two companies:

First, Alcoa (NYSE: AA) , which Goldman now thinks will be worth $15 a share by year-end, up from a prior estimate of $12. And second, Dutch specialty aluminum producer Constellium N.V. (NYSE: CSTM) , which Goldman has just upgraded to conviction buy and assigned a $35 price target.

Of the two, I think Constellium is the better bet. While hardly a household name in the U.S., Constellium sports some numbers that investors should really. Unlike unprofitable Arcelor, this stock sells for about 16.2 times earnings, and carries only a very modest debt load. Constellium's quality of earnings are strong, with trailing free cash flow of $160 million actually exceeding reported net income under GAAP of $154 million. If all the company manages to accomplish over the next 10 years is grow its profits at the rate of sales growth that Goldman is positing, the stock looks fairly priced to me. If profits grow faster than sales, however -- as you'd expect to happen as the business gains scale -- the stock could be an outright bargain.

Not so with Alcoa.

Here, we're looking at a smokestack industry giant fully as indebted and fully as unprofitable as ArcelorMittal. Alcoa reported losses of $2.3 billion last year, and carries a $6.9 billion net-debt load. While the company did generate positive free cash flow of $385 million, that's only enough to give it a 31 times price-to-free cash flow ratio.

Result: 14% growth won't be enough to justify Alcoa's valuation. To be worth buying, Alcoa will have to hit, or exceed, the 32% projected growth rate shown for it on Yahoo! Finance -- not an impossible task, but a whole lot harder to accomplish than the mid-teens growth that would justify an investment in Constellium.

In short: I have just as much conviction as Goldman has about Constellium being a buy. But I'm still not convinced about Alcoa.

Rich Smith has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Ford.

Comments from our Foolish Readers

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I don't agree with the report on Arcelor. Arcelor Mittal indeed has high debts, but there is significant change in the operations. Arcelor keeps up investing in its own factories, besides the steel market is picking up steam and the intrinsic value of the biggest steel company in the world is around 20 euro per share. So at this moment the stock is heavily undervalued and cheap at 12,25 euro per share. I think overall Arcelor has a good chance to surprise us all in their worldwide steel business. Having no debt doesn't mean that it's bad for the company if the investments of the past and present pay out in the future. It's a sign that mr. Mittal knows what he's talking about. It's an investor of significant allure, and he proved that to the world by his career to become one of the wealthiest men of today. I know, Americans nowadays are frantic of debt. But debt isn't so bad if you can pay it back. And he does so, as we have seen recently.

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As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.
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